Capitalizing on Fed Rate Cuts: A Guide to Emerging Market Local Currency Bonds

Summary:

• With the Federal Reserve signaling imminent interest rate cuts starting in September, now may be an opportune time to consider investing in emerging market (EM) bonds, particularly those denominated in local currencies, as they offer attractive yields, portfolio diversification, and inflation protection through their elevated real yields.
• There is potential for appreciation in EM currencies, especially in countries where real interest rates have been kept high to combat inflation and where significant rate cuts are anticipated. Investors could benefit from both bond price gains and currency appreciation as markets view these rate cuts as a sign of economic stabilization.
• Investors should be mindful of the risks associated with EM bonds, including currency volatility, the possibility of a global recession, and liquidity challenges. To mitigate these risks, investing in EM Local Bond ETFs may be a more effective strategy than selecting individual bonds. We look at four of the most popular options.

Why Now is the Moment to Consider Emerging Market Bonds

Emerging market (EM) local-currency debt has faced significant challenges in the first half of the year, primarily due to rising yields and a stronger U.S. dollar. This has led to widespread losses across the asset class, with only China and South Africa showing positive 1H returns.

However, with the Federal Reserve signaling imminent interest rates cuts to begin from the September FOMC meeting, it may be an opportune moment to consider investing in emerging market (EM) bonds, particularly those denominated in local currencies. As global economic conditions evolve, several factors could make EM bonds an attractive option for investors seeking yield and diversification.

Advantages of Investing in Local Currency Emerging Market Bonds

1. Attractive Yields: EM local bonds are currently offering yields around 7% on average, which is significantly higher than the yields on U.S. Treasuries. This yield differential, which is around 350 basis points, has historically led to strong outperformance of EM bonds when compared to U.S. bonds.
2. Diversification: EM local debt offers low correlation with both U.S. stocks and bonds. This low correlation can improve portfolio diversification, reducing overall risk while providing exposure to high-growth markets.
3. Inflation Protection: Many EM countries have higher real yields due to inflationary pressures. With inflation expected to peak and decline, the real yields on EM bonds remain attractive, offering a buffer against inflation.
4. Potential for Currency Appreciation: Investing in local currency bonds offers exposure to emerging market (EM) currencies, which are currently undervalued relative to the U.S. dollar. As the dollar weakens, these currencies may appreciate, potentially boosting returns on these bonds. There is considerable potential for appreciation in the currencies and local bonds of emerging markets where real interest rates have been kept excessively high to combat inflation, and where larger rate cuts are anticipated. Investors could benefit from both bond price gains and currency appreciation as markets interpret these rate cuts as a sign of stabilizing or improving economic conditions. Additionally, emerging markets often maintain a relative yield advantage: they start with higher interest rates, and even after rate cuts, they may still offer yields significantly higher than those in the U.S. Country that might benefit from this may be Brazil, South Africa Mexico, and in Europe Hungary.
5. Historical Outperformance: Historically, periods where EM bond yields have significantly outpaced U.S. Treasuries have been followed by substantial outperformance of EM bonds. This trend suggests a strong potential for future gains, particularly as global inflation stabilizes and growth prospects improve.

Disadvantages and Risks of Investing in Local Currency Emerging Market Bonds

1. Currency Volatility: One of the main risks associated with EM local bonds is currency volatility. While the potential for currency appreciation exists, fluctuations in exchange rates can negatively impact returns, especially if the U.S. dollar strengthens unexpectedly. That’s why it’s key to cherry pick on emerging market debt with a strong carry advantage. Countries where real rates have dropped substantially might be more exposed to currency volatility.
2. Global Recession and Flight to Safety: In the event of a global recession, investors may flee to safer assets like U.S. Treasuries, causing EM bonds to underperform. This flight to safety can also lead to a strengthening U.S. dollar, further eroding the returns on EM local bonds.
3. Political and Economic Risks: EM countries often face higher political and economic instability. Changes in government policies, geopolitical tensions, or economic crises can significantly affect bond markets and lead to higher default risks.
4. Liquidity Risks: While EM local bonds are becoming more liquid, they can still be less liquid than developed market bonds, particularly during periods of market stress. This can make it harder to exit positions without impacting the market price.

ETFs: An Effective Investment Tool for Accessing Emerging Market Local Currency Bonds

Investing in emerging market (EM) local currency bonds through ETFs offers key advantages over selecting individual bonds:

1. Diversification: ETFs provide broad exposure to bonds from multiple EM countries, reducing the risk tied to any single country’s economic or political instability.

2. Liquidity: ETFs are easily traded on stock exchanges, offering greater liquidity compared to individual EM bonds, which can be difficult to buy or sell, especially in less liquid markets.

3. Lower Costs: ETFs aggregate transaction costs, making them more cost-effective than buying individual bonds, which often come with higher fees and spreads.

4. Professional Management: ETFs are managed by experts who navigate the complexities of EM markets, offering investors the benefit of informed bond selection and portfolio management.

5. Accessibility: ETFs allow investors to access a diverse range of EM bonds with lower capital requirements, making it easier to invest in this asset class.

Popular EM Local Bond ETFs and Why They Are Favored

Investors looking to gain exposure to emerging market (EM) local currency bonds have several ETF options that provide diversified access to this asset class. Below are some of the most popular EM local bond ETFs, including options with Key Information Documents (KIDs) available for European investors.

1. iShares J.P. Morgan EM Local Government Bond UCITS ETF (Ticker: IEML)

• Why It's Popular: This ETF tracks the J.P. Morgan GBI-EM Global Diversified Index, providing broad exposure to government bonds issued in local currencies by emerging market countries. It's a popular choice due to its wide geographic diversification and relatively low expense ratio.
• 12 Month Dividend Yield: 5.5%
• For European Investors: UCITS compliant, KID available.

2. VanEck Vectors J.P. Morgan EM Local Currency Bond UCITS ETF (Ticker: EMLC)

• Why It's Popular: EMLC is one of the largest and most liquid EM local bond ETFs, offering exposure to local currency bonds from over 15 emerging market countries. It’s well-regarded for its low tracking error and strong performance relative to its benchmark.
• 12 Month Dividend Yield: 6%
• For European Investors: UCITS compliant, KID available.

3. SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (Ticker: EBND)

• Why It's Popular: This ETF offers exposure to a broad range of local currency-denominated government bonds from emerging markets. It tracks the Bloomberg Barclays Emerging Markets Local Currency Government Bond Index and is known for its competitive pricing and strong liquidity.
• 12 Month Dividend Yield: 5.5%

4. WisdomTree Emerging Markets Local Debt Fund (Ticker: ELD)

• Why It's Popular: This ETF provides exposure to debt issued in the local currencies of emerging market countries. It's favored for its active management approach, which aims to outperform standard benchmarks by selecting bonds with favorable risk-adjusted returns. Although this ETF is primarily targeted at U.S. investors, it provides an alternative for those looking for active exposure in EM local currency bonds.
• 12 Month Dividend Yield: 5.25%